When sustainable investment is discussed, the conversation is often focused on the publicly listed arena. However, as the environment, social and governance movement gains momentum, fund managers are looking to build ESG frameworks around the trickier, more illiquid assets such as private equity, hedge funds and property.

According to Henrik Steffenson, vice president of marketing and business development of Swiss based Asset 4, a provider of integrated financial and extra-financial research, there has been an increase in the number of mainstream investors looking to incorporate ESG criteria into their investment processes and research for alternatives as well as traditional asset classes. Although this might seem a bit contradictory for investments such as hedge funds and private equity, fund managers are demanding more transparency from companies whether they are listed or not.

One of the underlying reasons is the launch of The United Nations Principles for Investments (PRI) in April 2006 which encourages institutions to behave in a more responsible and accountable manner across their investment spectrum. Currently, the sustainable spotlight is being shone on the real estate industry with the recent launch of the Working Group on Responsible Property Investment by the UN Environment Finance Initiative (UNEP FI).

The aim is to encourage sustainability in mainstream property finance. At the time of the announcement, Jean-Pierre Sicard, head of sustainable development at Caisse des Dépôts and co-chair of the working group, says: “Investors’ responsibility cannot be limited to their assets in large listed companies. The environmental and social stakes in real estate must be a subject of investors’ benchmarking to prepare property responsible investment practices.”

According to Rory Sullivan, head of investor responsibility, at Insight Investments, property is easier to adapt to ESG criteria than hedge funds and private equity because certain issues such as climate change, physical risks and emissions can be quantified. For example, a recent UK report estimated that, through their construction, use and demolition, built structures are the source for nearly 50% of carbon emissions. Property managers can take tangible steps to reduce their carbon footprint by implementing tangible energy efficient measures.

Prudential Property Investment Managers (PRUPRIM), which is part of the UK insurer Prudential, is one of the pioneers in the field, being the UK’s only real estate investment manager to achieve certification to ISO 14001, an internationally recognised environmental management standard. This year, PRUPRIM launched its so called improver portfolio which covers 28 existing properties worth about £500m (€734m) across the real estate spectrum.

Paul McNamara, head of research at PRUPRIM, says: “We believe it is our fiduciary responsibility to look at no and low cost initiatives where we can reduce our environmental footprint without harming the investment performance of the portfolio. We are taking a baseline environmental audit of the properties in the improver portfolio which include shopping centres, retail warehouses and office buildings and we intend to roll out the lessons that we learn to other property investments. Many of these measures are relatively simple and small scale. For example, by simply removing one of every three lighting tubes in a shopping centre car park and painting the ceiling white, we can cut energy costs by over a quarter.”

The firm also takes seriously its corporate governance responsibilities in terms of its procurement practices with suppliers plus its engagement with the local communities where its properties are located. It will use space in a local shopping centre, for example, to provide training in the retail sector for long term unemployed.

In the long run, McNamara believes laying the ESG foundations now will translate into enhanced long-term performance. “We have seen attitudes change with respect to sustainability. Investors and tenants are becoming increasingly selective about what they will invest in or lease. There is also increasing political pressure and stringent regulations that raise the standards by which properties need to be managed. As a result, properties that have been made more environmentally sustainable will prove more lettable and saleable and could perform relatively better than non-sustainable buildings.”

There are also a handful of specialised sustainable property funds such as the Igloo Regeneration Fund, which came onto the scene five years ago and is jointly managed between Morley Fund Management and Igloo Developments. Currently, the portfolio of projects has a completed development value of about £2.5bn, creating around 8,500 homes and nearly 10,000 jobs on about 100 hectares of brownfield land as well as reducing fossil fuel use by more than 50%.

Private equity is also being incorporated into the ESG fold although the challenges are greater due its lack of transparency. The industry has also been in the centre of a storm over the record sums being raised and whether private equity firms can truly add value. Private equity managers respond by claiming in today’s more accountable environment, investors are demanding and asking for a much more detailed due diligence process to be undertaken for potential
investments.

Given the sums involved, investors are also keeping a careful eye on the bottom line. Stephan Illenberger, managing director of AXA Private Equity in Germany, notes: “I doubt that we would have seen a scandal on the scale of Worldcom in private equity because the management is under such scrutiny from investors. They are monitoring the financials on a monthly basis to ensure that corrections are made quickly when necessary. The difference to other asset classes is that private equity investors are looking on the cash flow in order to pay down the debt.”

Investors can also adopt the same ethical or socially responsible stance they do in the public space and avoid investing in private equity funds whose underlying holdings they deem to be unethical. This can cover a wide range of activities such as tobacco, alcohol, defence, stem cell research and poor labour practices.

However, given the recent spate of giant private equity firms trying to buy household names such as Boots and Gap, one question is what happens to their detailed corporate governance practices if they are taken private? Dr Steve Waygood, head of SRI Engagement at Morley Fund Managers, believes “they should continue to act responsibility because these companies have a broader role in society and responsibility to other stakeholders. It would hurt their brand and reputations and they could lose business. It would also create problems with their unions.”

Equally as important, if they are not compliant, it will make it that much harder to reappear on the public scene. Emma Hunt, senior consultant and head of responsible investment in Europe for Mercer, explains: “If a listed company is taken private, chances are it will return to the stock market when its new owners look to exit. It would therefore not make sense to dismantle the good environmental, social and governance practices it would have built while in public ownership.”

Hedge funds also come with their own set of problems. A report published by The UK Social Investment Forum last year pointed out that hedge funds can present a number of deficiencies in transparency and risk control. Also, due to the lack of widely varying benchmarking methods, it can be particularly difficult to evaluate or compare performance between hedge funds. Moreover, limited reporting requirements can make it difficult to obtain accurate or sufficient information about some funds.

Over the past few years, a handful of green hedge funds have been launched including UK-based Armajaro Asset Management’s market-neutral Coolum Strategus SRI fund, Morely’s SRI Long/Short fund, US-based Winslow Hedge Fund and Green Cay Asset Management’s four market neutral funds.

However, as Jack Robinson, founder of Winslow, an independent US based investment management firm, warns the green label can be misleading. “The basic concept in our fund is to go long the greens and short the dirties. There have been a plethora of young technology companies coming to the market but just because they are green does not mean they are well-managed. If they do not meet our fundamental investment criteria we will not invest in them.”